By Alex Mumblat

The GovCon M&A Dilemma

Despite the challenging economic climate, many government contractors have maintained solid financial performance throughout the Coronavirus pandemic. But exposure to a host of uncontrollable risks means that continued growth is far from certain.

Recent stimulus spending and US Federal Reserve interventions have bolstered the GovCon industry, but these catalysts may be short-lived and double-edged. In response to increased deficit spending, federal and state tax rate increases are likely.

Higher taxes would not only tighten corporate cash flows - business valuations and after-tax sale proceeds will likely be negatively affected as well. GovCon businesses considering a near-term liquidity event may encounter shrinking windows of opportunity.    

Under any circumstances, GovCon M&A can be daunting.

Various Federal restrictions may complicate third party sales. These include:

  • The Anti-Assignment Act
  • Novation Requirements
  • National Security Requirements
  • Small Business Designations

Set-aside firms face added constraints.

Minority and veteran-owned contractors, in addition to other firms with special designations under Section 8(a) of the Small Business Act, are granted certain competitive advantages in the RFP process. To capitalize on these benefits, a set-aside firm's shareholders must maintain a majority stake in the business or be acquired by a firm with the same designation. This can further limit a company's transaction options and create a significant M&A dilemma.

With these pitfalls in mind, many GovCon firms have turned to employee stock ownership plans (ESOPs) as M&A alternatives. Although ESOPs sales are less commonplace, these transactions carry a number of attractive features.

ESOPs are defined contribution plans that invest in employer securities.

When company stock is sold to an employee trust (at a fair market valuation), selling shareholders can defer/eliminate capital gains taxes on the proceeds, while their companies gain substantial income tax deductions. A business is entitled to these tax benefits when it sells at least a 30% stake to an employee trust. As a result, partial ESOP transactions are typical. This sort of structure can create a meaningful liquidity event without the threat of losing an 8(a) certification.

Cost-plus contractors may be eligible for additional ESOP benefits.

Qualified retirement plan contributions are allowable under Federal Accounting Rules (FAR). As a result, government contractors operating on a cost-plus basis can include ESOP contributions in their expense reimbursement submissions. This can significantly enhance the ESOP sponsor’s free cash flow.

The CARES Act created an additional, short-term ESOP incentive.

Passed by Congress at the pandemic’s onset, the CARES Act allows companies to carry back losses incurred in the 2018, 2019, and 2020 tax years. GovCon firms often have high payrolls. When they sponsor an ESOP, these companies can make annual plan contributions equivalent to 25% of payroll. The ESOP contributions create a non-cash expense that can offset or exceed a company’s current-year income. As the result, these net operating losses (NOLs) can be applied against a firm’s income in prior years and generate tax refunds.

But for many GovCon firms, added stability is an ESOP's most important asset.

An ESOP sale often represents a path forward, rather than a way out, for selling shareholders. Many maintain meaningful roles with their firms and continue to build their business legacies. Meanwhile, employee-owned firms benefit from stronger staff engagement, higher retention rates, and a stronger value proposition in the hiring market.

In the highly competitive world of government contracting, these intangible benefits can be just as meaningful as an ESOP’s financial appeal.